Answers to Warm-Up Exercises

E12-1. Sensitivity analysis Answer: Using the 12% cost of capital to discount all of the cash flows for each scenario to yield the following NPVs, resulting in a NPV range of $19,109.78: Pessimistic $3,283.48 E12-2. Using IRR selection criteria Answer: The minimum amount of annual cash inflow needed to earn 8% is $11,270.54 N 5, I 8%, PV $45,000 Solve for PMT N 5, PV $11,270.54 $12,500 Most Likely $6,516.99 Optimistic $15,826.30

The IRR of the project is 12.05%. $45,000, PMT $12.05% Solve for I

The project is acceptable since its IRR exceeds the firms 8% cost of capital. Since the required cash flow is much less than the anticipated cash flow, one would expect the IRR to exceed the required rate of return. E12-3. Risk-adjusted discount rates RADR $5,500 7.0% N 7, I 7%, PMT

Answer: Project Sourdough

Solve for PV $29,641.09 NPV PVn Initial investment NPV $29,641.09 $12,500 NPV $17,141.09 Project Greek Salad N 7, I 8%, PMT RADR $4,000 8.0%

Solve for PV $20,825.48 NPV PVn Initial investment NPV $20,825.48 $7,500 NPV $13,325.48 Yeastime should select Project Sourdough. E12-4. ANPV

Answer: You may use a financial calculator to determine the IRR of each project. Choose the project with the higher IRR. Project M Step 1: Find the NPV of the project

NPVM Key strokes CF0 -$35,000, CF1 $12,000, CF2 Set I 8% Solve for NPV $21,359.55 Step 2: Find the ANPV N 3, I 8, PV $21,359.55 $8,288.22 Solve for PMT

$25,000, CF3

$30,000

Project N Step 1: Find the NPV of the project NPVM Key strokes CF0 -$55,000, CF1 $18,000, CF2 $15,000, CF3 $25,000 CF4 $10,000, CF5 $8,000, CF6 $5,000, CF7 $5,000 Set I 8% Solve for NPV $13,235.82 Step 2: Find the ANPV N 7, I 8, PV $13,235.82 $2,542.24 Solve for PMT E12-5. NPV profiles

Based on ANPV, you should advise Outcast, Inc. to choose Project M.

Answer: The investment opportunity schedule (IOS) in this problem does not allow us to determine the maximum NPV allowed by the budget constraint. In order to determine whether the IOS maximizes the NPV for Longchamps Electric, we will need to know the NPV for each of the six projects. However, it does appear likely that Longchamps Electric will maximize firm value by selecting Project 4 (IRR 11%), Project 2 (IRR 10%), and Project 5 (IRR 9%). The total investment in these three projects will be $135,000, leaving $15,000 excess cash for future investment opportunities.

Solutions to Problems
P12-1. Recognizing risk LG 1; Basic a. and b. Project A Risk Low Reason The cash flows from the project can be easily determined since this expenditure consists strictly of outflows. The amount is also relatively small. The competitive nature of the industry makes it so that Caradine will need to make this expenditure to remain competitive. The risk is only moderate since the firm already has clients in place to use the new technology. Since the firm is only preparing a proposal, their commitment at this time is low. However, the $450,000 is a large sum of money for the company and it will immediately become a sunk cost. Although this purchase is in the industry in which Caradine normally operates, they are encountering a large amount of risk. The large expenditure, the competitiveness of the industry, and the political and exchange risk of operating in a foreign country add to the uncertainty.

Medium

Medium

High

Note: Other answers are possible depending on the assumptions a student may make. There is too little information given about the firm and industry to establish a definitive risk analysis.

P12-2. Breakeven cash flows LG 2; Intermediate a. N 12, I 14%, PV $35,000 Solve for PMT $6,183.43 b. N 12, I 10%, PV $35,000 Solve for PMT $5,136.72 The required cash flow per year would decrease by $1,047.27. P12-3. Breakeven cash inflows and risk LG 2; Intermediate a. Project X Project Y N 5, I 15%, PMT $10,000 N 5, I 15%, PMT $15,000 Solve for PV 33,521.55 Solve for PV $50,282.33 NPV PV initial investment NPV PV initial investment NPV $33,521.55 $30,000 NPV $50,282.33 $40,000 NPV $3,521.55 NPV $10,282.33 b. Project X Project Y N 5, I 15%, PV $30,000 N 5, I 15%, PV $40,000 Solve for PMT $8,949.47 Solve for PMT $11,932.62 c. Project X Project Y Probability 60% Probability 25% d. Project Y is more risky and has a higher potential NPV. Project X has less risk and less return while Project Y has more risk and more return, thus the risk-return tradeoff. e. Choose Project X to minimize losses; to achieve higher NPV, choose Project Y. P12-4. Basic scenario analysis LG 2; Intermediate a. Range A $1,800 $200 b.

$1,600 Range B

$1,100

$900

$200

NPVs Outcome Pessimistic Most likely Optimistic Range c. Project A $ 6,297.29 513.56 7,324.41 $13,621.70 Project B $ 337.79 513.56 1,364.92 $1,702.71

Although the most likely outcome is identical for Project A and B, the NPV range varies considerably. d. Project selection would depend upon the risk disposition of the management. (A is more risky than B but also has the possibility of a greater return.)

P12-5. Scenario analysis LG 2; Intermediate a. Range P $1,000 $500 $500 Range Q $1,200 $400 $800 b. NPVs Outcome Pessimistic Most likely Optimistic c. Project P $72.28 1,608.43 3,144.57 Project Q $542.17 1,608.43 4,373.48

Range P $3,144.57 $72.28 $3,072.29 Range Q $4,373.48 ( $542.17) $4,915.65 Each computer has the same most likely result. Computer Q has both a greater potential loss and a greater potential return. Therefore, the decision will depend on the risk disposition of management.

P12-6. Personal Finance: Impact of inflation on investments LG 2; Easy a. c.

Year 0 1 2 3 4 5

Investment Higher Lower Cash Current Inflation Inflation Flows NPV (a) NPV (b) NPV (c) (7,500) 2,000 2,000 2,000 1,500 1,500 (7,500) 1,878 1,763 1,656 1,166 1,095 $ 58 (7,500) 1,860 1,731 1,610 1,123 1,045 $ (131) (7,500) 1,896 1,797 1,703 1,211 1,148 $ 254

Total NPV

d. As the inflation rate rises the NPV of a given set of cash flows declines. P12-7. Simulation LG 2; Intermediate a. Ogden Corporation could use a computer simulation to generate the respective profitability distributions through the generation of random numbers. By tying various cash flow assumptions together into a mathematical model and repeating the process numerous times, a probability distribution of project returns can be developed. The process of generating random numbers and using the probability distributions for cash inflows and outflows allows values for each of the variables to be determined. The use of the computer also allows for more sophisticated

simulation using components of cash inflows and outflows. Substitution of these values into the mathematical model yields the NPV. The key lies in formulating a mathematical model that truly reflects existing relationships. b. The advantages to computer simulations include the decision makers ability to view a continuum of risk-return tradeoffs instead of a single-point estimate. The computer simulation, however, is not feasible for risk analysis. P12-8. Risk-adjusted discount ratesBasic LG 4; Intermediate a. Project E N 4, I 15%, PMT $6,000 Solve for PV $17,129.87 NPV $17,129.87 $15,000 NPV $2,129.87 Project F CF0 -$11,000, CF1 $6,000, CF2 Set I 15% Solve for NPV $1,673.05 $4,000, CF3 $5,000, CF4 $2,000

Project G CF0 -$19,000, CF1 $4,000, CF2 $6,000, CF3 Set I 15% Solve for NPV $1,136.29 Project E, with the highest NPV, is preferred. b. RADRE 0.10 (1.80 (0.15 0.10)) 0.19 RADRF 0.10 (1.00 (0.15 0.10)) 0.15 RADRG 0.10 (0.60 (0.15 0.10)) 0.13 c. Project E N 4, I 19%, PMT $6,000 Solve for PV $15,831.51 NPV $15,831.51 $15,000 NPV $831.51 Project F Same as in part a, $1,673.05 Project G CF0 -$19,000, CF1 $4,000, CF2 Set I 13% Solve for NPV $2,142.93 Rank 1 2 3 Project G F E $6,000, CF3

$8,000, C44

$12,000

$8,000, CF4

$12,000

d. After adjusting the discount rate, even though all projects are still acceptable, the ranking changes. Project G has the highest NPV and should be chosen. P12-9. Risk-adjusted discount ratesTabular LG 4; Intermediate a. Project A N 5, I 8%, PMT $7,000 Solve for PV $27,948.97 NPV $27,948.97 $20,000 NPV $7,948.97 Project B N 5, I 14%, PMT $10,000 Solve for PV $34,330.81 NPV $34,330.81 $30,000 NPV $4,330.81 Project A, with the higher NPV, should be chosen. b. Project A is preferable to Project B, since the NPV of A is greater than the NPV of B. P12-10. Personal Finance: Mutually exclusive investment and risk LG 4; Intermediate a. N 6, I 8.5%, PMT $3,000 Solve for PV 13,660.76 NPV $13,660.76 $10,000 NPV $3,660.76 b. N 6, I 10.5%, PMT $3,800 Solve for PV $16,310.28 NPV $16,31.28 $12,000 NPV $4,310.28 c. Using NPV as her guide, Lara should select the second investment. It has a higher NPV. d. The second investment is riskier. The higher required return implies a higher risk factor. P12-11. Risk-adjusted rates of return using CAPM LG 4; Challenge a. rX 7% 1.2(12% 7%) 7% 6% 13% rY 7% 1.4(12% 7%) 7% 7% 14% NPV calculation for X: N 4, I 13%, PMT $30,000 Solve for PV 89,234.14 NPV $89,234.14 $70,000 NPV $19,234.14 NPV calculation for Y: CF0 -$78,000, CF1 $22,000, CF2 $32,000, CF3 Set I 14% Solve for NPV $18,805.82

$38,000, CF4

$46,000

b. The RADR approach prefers Project Y over Project X. The RADR approach combines the risk adjustment and the time adjustment in a single value. The RADR approach is most often used in business. P12-12. Risk classes and RADR LG 4; Basic a. Project X CF0 -$180,000, CF1 $80,000, CF2 CF4 $60,000, CF5 $60,000 Set I 22% Solve for NPV $14.930.45 Project Y CF0 -$235,000, CF1 $50,000, CF2 $60,000, CF3 $70,000, CF4 $80,000, CF5 $90,000 Set I 13% Solve for NPV $2,663.99 Project Z CF0 -$310,000, CF1 $90,000, CF2 $90,000, CF3 CF4 $90,000, CF5 $90,000 [or, CF0 -$310,000, CF1 $90,000, F1 5] Set I 15% Solve for NPV -$8,306.04 $90,000, $70,000, CF3 $60,000,

b. Projects X and Y are acceptable with positive NPVs, while Project Z with a negative NPV is not. Project X, with the highest NPV, should be undertaken. P12-13. Unequal livesANPV approach LG 5; Intermediate a. Machine A CF0 -$92,000, CF1 $12,000, CF2 $12,000, CF3 CF4 $12,000, CF5 $12,000, CF6 $12,000 [or, CF0 -$92,000, CF1 $12,000, F1 6] Set I 12% Solve for NPV -$42,663.11 Machine B CF0 -$65,000, CF1 $10,000, CF2 Set I 12% Solve for NPV $6,646.58 $20,000, CF3

$12,000,

$30,000, CF4

$40,000

Machine C CF0 -$100,500, CF1 $30,000, CF2 $30,000, CF3 $30,000, CF4 $30,000, CF5 $30,000 [or, CF0 -$105,000, CF1 $30,000, F1 5]

Set I 12% Solve for NPV Rank 1 2 3

$7,643.29

Machine C B A

(Note that Machine A is not acceptable and could be rejected without any additional analysis.) b. Machine A N 6, I 12%, PV $42,663.11 Solve for ANPV (PMT) $10,376.77 Machine B N 4, I 12%, PV $6,646.58 Solve for ANPV (PMT) $2,188.28 Machine C N 5, I 12%, PV $7,643.29 Solve for ANPV (PMT) $2,120.32 Rank 1 2 3 c. Machine B C A

Machine B should be acquired since it offers the highest ANPV. Not considering the difference in project lives resulted in a different ranking based in part on Machine Cs NPV calculations.

P12-14. Unequal livesANPV approach LG 5; Intermediate a. Project X CF0 -$78,000, CF1 $17,000, CF2 Set I 14% Solve for NPV $2,698.32 Project Y CF0 -$52,000, CF1 $28,000, CF2 Set I 14% Solve for NPV $1,801.17

$25,000, CF3

$33,000, CF4

$41,000

$38,000

Project Z CF0 -$66,000, CF1 $15,000, CF2 $15,000, CF3 $15,000, CF4 CF5 $15,000, CF6 $15,000, CF7 $15,000, CF8 $15,000 [or, CF0 -$66,000, CF1 $15,000, F1 8] Set I 14% Solve for NPV $3,582.96

$15,000,

Rank 1 2 3

Project Z X Y

b. Project X N 4, I 14%, PV $ Solve for ANPV (PMT)

$9,260.76

Project Y N 2, I 14%, PV $1801.17 Solve for ANPV (PMT) $1,093.83 Project Z N 5, I 14%, PV $3582.96 Solve for ANPV (PMT) $1,043.65 Rank 1 2 3 c. Project X Y Z

Project Y should be acquired since it offers the highest ANPV. Not considering the difference in project lives resulted in a different ranking based primarily on the unequal lives of the projects.

P12-15. Unequal livesANPV approach LG 5; Intermediate a. Sell CF0 -$200,000, CF1 $200,000, CF2 Set I 12% Solve for NPV $177,869.90 $250,000

License CF0 -$200,000, CF1 $250,000, CF2 $100,000 CF3 $80,000, CF4 $60,000, CF5 $40,000 Set I 12% Solve for NPV $220,704.25 Manufacture CF0 -$450,000, CF1 $200,000, CF2 $250,000, CF3 CF4 $200,000, CF5 $200,000, CF6 $200,000 [or, CF0 -$450,000, CF1 $200,000, F1 1, CF2 $250,000, F2 1, CF3 $200,000, F3 4] Set I 12% Solve for NPV $412,141.16 $200,000,

Rank 1 2 3

Alternative Manufacture License Sell

b. Sell N 2, I 12%, PV $ Solve for ANPV (PMT)

$105,245.28

License N 5, I 12%, PV $220,704.25 Solve for ANPV (PMT) $61,225.51 Manufacture N 6, I 12%, PV $412,141.16 Solve for ANPV (PMT) $100,243.33 Rank 1 2 3 c. Alternative Sell Manufacture License

Comparing the NPVs of projects with unequal lives gives an advantage to those projects that generate cash flows over the longer period. ANPV adjusts for the differences in the length of the projects and allows selection of the optimal project. This technique implicitly assumes that all projects can be selected again at their conclusion an infinite number of times.

P12-16. NPV and ANPV decisions LG 5; Challenge a. b. Unequal-Life Decisions Annualized Net Present Value (ANPV) Samsung Cost Annual Benefits Life Terminal value Required rate of return a. CF0 -$2,350, CF1 $900, CF2 Set I 9% Solve for NPV $237.04 $(2,350) $900 3 years $400 9.0% $900, CF3 Sony $(2,700) $1,000 4 years $350 9.0% $1,300

$900 + $400

b. N 3, I 9%, PV $237.04 Solve for ANPV (PMT) $93.64 c. CF0 -$2,700, CF1 Set I 9% $1,000, CF2 $1,000, CF3 $1,000, CF4 $1,000 + $350 $1,350

Solve for NPV

$787.67

d. N 4, I 9%, PV $787.67 Solve for ANPV (PMT) $243.13 e. Richard and Linda should select the Sony set because its ANPV of $243.13 is greater than the $93.64 ANPV of Samsung.

P12-17. Real options and the strategic NPV LG 6; Intermediate a. Value of real options value of abandonment value of expansion value of delay Value of real options (0.25 $1,200) (0.30 $3,000) (0.10 $10,000) Value of real options $300 $900 $1,000 $2,200 NPVstrategic NPVtraditional Value of real options 1,700 2,200 $500 b. Due to the added value from the options Rene should recommend acceptance of the capital expenditures for the equipment. c. In general this problem illustrates that by recognizing the value of real options a project that would otherwise be unacceptable (NPVtraditional 0) could be acceptable (NPVstrategic 0). It is thus important that management identify and incorporate real options into the NPV process. P12-18. Capital rationingIRR and NPV approaches LG 6; Intermediate a. Rank by IRR Project F E G C B A D IRR 23% 22 20 19 18 17 16 Initial Investment $2,500,000 800,000 1,200,000 Total Investment $2,500,000 3,300,000 4,500,000

Projects F, E, and G require a total investment of $4,500,000 and provide a total present value of $5,200,000, and therefore an NPV of $700,000. b. Rank by NPV (NPV Project F A C B D G E PV Initial investment) NPV $500,000 400,000 300,000 300,000 100,000 100,000 100,000 Initial Investment $2,500,000 5,000,000 2,000,000 800,000 1,500,000 1,200,000 800,000

Project A can be eliminated because while it has an acceptable NPV, its initial investment exceeds the capital budget. Projects F and C require a total initial investment of $4,500,000 and provide a total present value of $5,300,000 and a net present value of $800,000. However,

the best option is to choose Projects B, F, and G, which also use the entire capital budget and provide an NPV of $900,000. c. The internal rate of return approach uses the entire $4,500,000 capital budget but provides $200,000 less present value ($5,400,000 $5,200,000) than the NPV approach. Since the NPV approach maximizes shareholder wealth, it is the superior method.

d. The firm should implement Projects B, F, and G, as explained in part c. P12-19. Capital RationingNPV Approach LG 6; Intermediate a. Project A B C D E F G PV $384,000 210,000 125,000 990,000 570,000 150,000 960,000 Initial Investment Total Investment

$100,000

$100,000

$100,000 $800,000

$200,000 $1,000,000

b. The optimal group of projects is Projects C, F, and G, resulting in a total net present value of $235,000. Project G would be accepted first because it has the highest NPV. Its selection leaves enough of the capital budget to also accept Project C and Project F. P12-20. Ethics problem LG 4; Challenge Student answers will vary. Some students might argue that companies should be held accountable for any and all pollution that they cause. Other students may take the larger view that the appropriate goal should be the reduction of overall pollution levels, and that carbon credits are a way to achieve that goal. From an investor standpoint, carbon credits allow the polluting firm to meet legal obligations in the most cost-effective manner, thus improving the bottom line for the company and investor.